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February gold futures broke $1200 for the first time a little after 4AM New York time. February 2010 is now the major front month contract after the expiration of the December contract on November 30th.

Gold futures were up 14% in November, the best monthly performance in ten years. Silver was also up 14%. Gold traded down only three days in November and hit one all-time high after another during that time. While the major U.S. stock indices were also up, gold and silver shined in comparison. Seasonally-weak oil was flat during the month. The trade-weighted U.S. dollar opened November above 76 and closed out below 75, hitting a new yearly low of 74.23 in the interim.

The price rise in gold is caused by a positive supply demand picture both for the physical metal and in the futures trading pits. For the last twenty years there have been three major sources of gold supply and three major destinations of gold demand. The sources for supply have been mining, scrap (also known as recycled gold) and central bank selling. The three majors uses for gold have been for jewelery, investment and industrial (contrary to popular belief, gold has a wide variety of uses in manufacturing, especially in electronics). Complicating the picture has been central bank leasing to miners, big banks and hedge funds that dumped significant amounts of gold on the market in the 1980s and 1990s and was a major factor in holding gold prices down. The unwinding of these positions, Barrick Gold closing out its hedge book is the most recent example, has been creating upward pressure on gold prices for several years now.

There are two major currents in the shift in market supply and demand. Central banks have shifted from the supply side to the demand side and ETFs have caused a major increase in investment demand. Up to mid-decade, central bank selling accounted for 14% of gold market supply, but in the first half of 2009, central banks became net buyers of gold. As supply dried up from central banks a new increase in demand was created by ETFs that buy and store physical gold. There are now eleven of these globally and none existed before 2003. Their gold holdings have gone from zero to 1766.40 tonnes in the last six years. The largest ETF, GLD, is now the sixth biggest holder of gold in the world (between France and China).

Gold mining has provided as little as 60% of market supply in recent decades. So far gold mining output peaked in 2001. It then fell seven years in a row until 2008. The only major producers with increasing output have been China and Russia. This may have more to do with their transitions from a communist to a more capitalistic economic model than with the contents of their gold mines, however.

South Africa, which was the top gold producer for much of the last 100 years, is experiencing a rapid drop in gold output and it looks like it will fall to fourth place in global rankings this year. It takes approximately ten years to open a new gold mine and gold prices only started rising in 2001 and many remained convinced for some time that the rally wouldn't last. So don't expect any significant increase in mining output until well after 2010. Barrick Gold (NYSE:ABX) closing out its large hedge book though is an indication that they believe gold output is likely to continue falling and prices to continue rising.

While high gold prices mean that jewelery demand will fall, the rise in investment demand will more than overwhelm any drop. In a number of developing economies, jewelery and investment demand are not actually distinguishable as is. Purchasing high-carat jewelery is the traditional method of investing in gold. While India has been the number one market for gold demand, China seems to be in the process of overtaking it. There were significant restrictions that limited gold buying by the Chinese until the early 2000s. Gold demand there has been soaring since the restrictions were lifted.

There are a number of major long-term trend changes going on in the gold market and none of them are likely to end soon. There is probably at least another decade before a new equilibrium is established and major shifts start occurring again and drive the price of gold back down. By the time that happens though, the price of gold is going to be much, much higher than it is today.

Disclosure: Long gold and silver.

Source: Gold Soars on Falling Supply and Rising Demand